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Changes in P/E Ratios During the Current Bear Market

Piece I wrote earlier this week...

Multiple reasons to love low US inflation

Without fanfare, global equities markets have gained an unexpected fillip this week, with a development that looks capable of firing a fresh round of sharemarket buying support.
The catalyst is a clear break lower in United States long-term inflation expectations. This can deliver meaningful price/earnings multiple expansion for a market showing signs of wanting to track higher.
Over recent weeks, the S&P 500 has lifted almost 10 per cent, whilst the technology-based Nasdaq has climbed some 13 per cent. Even more impressive has been the recovery in the Value Line Index. This equal-weighted, broad-based equity index is more than 17 per cent off its lows.
This has reversed half of the losses that accrued from the 2007 high.
Whilst to date this recovery has been a stop-start affair, it's demonstrated an investor willingness to look beyond what will inevitably be a sluggish period of global growth over coming months and to focus instead on the expected recovery as 2009 unfolds.
But a fresh impetus has emerged, following a drop to new five-year lows in a reading of the implied long-term level of US inflation.
US 10-year Treasury Inflation Protected Securities, or TIPS, generate one of the best guides to investor expectations for inflation in the US. The "expected inflation" reading is calculated by deducting the yield on the inflation bond from the yield on the standard 10-year Treasury bond.
As oil threatened to break above $US150 a barrel in early July, this closely watched measure of long-term inflation pushed to a two-year high above 2.6 per cent.
But this week, with oil falling sharply, the TIPS inflation reading has dropped back to 2.14 per cent - a level last seen in October 2003.
Inflation expectations have a major impact on equity pricing - in particular a stock's price/earnings multiple. Higher inflation assumptions drive a lower P/E pricing environment, whilst diminishing inflationary concerns will invariably allow market multiples to expand.
Over the past nine months, with soaring energy and food prices raising inflationary expectations, equity markets have been subjected to significant P/E compression.
Morgan Stanley calculates the forward P/E on the S&P 500 at just 12.8 times - compared with more than 15 times in mid-2007. According to Goldman Sachs JBWere, the Australian market multiple is now less than 12 times - against readings of about 17 times in late 2007. These are levels not seen since inflation last spiked in the early 1990s.
But the shift in inflationary expectations over recent weeks has been dramatic. Sharply falling food and energy prices have had an immediate impact on investor thinking. So long as this sentiment shift is maintained, investors will soon take a second look at P/E pricing. And there is much to like about the prospect of market multiple expansion when pricing is already looking historically cheap.
A second positive has emerged over recent weeks. The dramatic recovery of the US dollar is supporting the view that the greenback may be in the process of reversing what has been a savage seven-year bear trend.
This is important as recent analysis has suggested that a strong US dollar is usually accompanied by above-average equity returns.
This may seem counter-intuitive, given the support offered to the US market over the past year by a weaker dollar. Exporters have benefited from a lower greenback, ensuring that net exports have largely been responsible for keeping US gross domestic product growth on a positive trajectory.
But given the long-term nature of dollar trends and the natural propensity for equity markets to rise, on average shares will tend to advance whether the dollar is moving up or down.
So it's the quantum of gains that accrue during periods of US strength or weakness that differentiate the relative appeal of the dollar trend.
US fund manager Bespoke Investment Group has calculated the average return of the S&P 500 during US dollar bull markets is more than 80 per cent. During periods of US dollar declines, the return falls to less than 20 per cent.
Given that equities and the US dollar may be undertaking coincident trend reversals, this prospect of 60 per cent relative trend outperformance bodes well for investor returns.